Canada Regulator Probes Re-Routing of Stock-Trade Orders to U.S.

Ben Dummett and Rita Trichur broke the news that Canada’s biggest securities regulator was probing the rerouting of stock trading volumes through U.S. broker-dealers to U.S. markets by Canadian banks and other big dealers amid concerns the trend could undermine the integrity of domestic equity exchanges.

10:45 AM EST:Canada Regulator Concerned About Impact of Loss of Order Flow

11:26 AM EST: Canada Regulator Looks into Rerouting of Stock-Trade Orders to U.S.

By Ben Dummett and Rita Trichur

TORONTO–Canada’s biggest securities regulator is probing the growing volume of stock trading that is being rerouted through U.S. broker-dealers by Canadian banks and other big dealers.

Concerned that a growing share of order flow is going to the U.S. at the expense of domestic exchanges, the Ontario Securities Commission is looking at how big Canadian dealers route retail-brokerage orders to different marketplaces. That will help the regulator to determine if rule changes are needed to retain order flow in Canada, said Susan Greenglass, the OSC’s director for market regulation.

Canadian dealers have traditionally directed at least some of their retail investor order flow to U.S. broker-dealers to execute and print trades for stocks listed both on the Toronto Stock Exchange and on a U.S. stock market or equity trading platform. But as domestic dealers face increasing pressure to cut costs, those southbound volumes stand to increase.

The Canadian regulator’s concern “is about the longer-term impact on the [Canadian] market if order flow is routed to the U.S. on a broad basis,” Ms. Greenglass said.

The Investment Industry Regulatory Organization of Canada, Canada’s main stock market watchdog, said it shares this concern.

The concern comes as U.S. regulators examine how broker-dealers in the U.S. route orders, and whether they favor internalizing order flow to execute trades from within their own inventory of stock. This practice, which some critics say is less transparent than on-exchange trades, enables the broker-dealers to capture the spread on millions of trades a day. Proponents say the practice makes trades cheaper for retail investors.

For Canadian retail stock brokerages, using U.S. broker-dealers offers a way to cut costs because U.S. broker-dealers can pay a rebate for order flow traded in the U.S. That rebate offsets a portion of the Canadian brokers’ trading costs.

Such rebates can’t be paid in Canada, making it more attractive for Canadian brokers to reroute trading in inter-listed stocks to the U.S. Some of the biggest broker-dealers that stand to benefit from this growing Canadian business are Citadel Securities, Citigroup Inc.’s Automated Trading Desk LLC, UBS Broker Services and KCG Holdings Inc.

U.S. broker-dealers say Canadian brokers use them primarily because they offer better trade execution. For one, the market-makers can offer Canadian retail brokerages prices that are cheaper than prices available on an exchange, according to a person familiar with the matter. On average, that discount amounts to 0.3 to 0.4 of a cent for market orders under 10,000 shares, which represents the vast majority of all retail flow, according to that person. Although those savings appear minuscule, they add up to hundreds of millions of dollars a year, that person added.

Last month Canada’s flagship stock market operator, TMX Group Ltd., announced a series of initiatives to deter the diversion of retail flow to U.S. exchanges. Among the changes, which take effect in June 2015, is a new trading model for TMX Group’s Alpha trading platform that will pay brokers a rebate for their active order flow. The new TMX Group model is also designed to discourage high-frequency traders, which use computer programs to rapidly buy and sell stocks, from executing orders, to make it easier for brokers to complete their retail transactions.

The exchange operator’s goal is “to replicate the economics [in the U.S.] so that those [Canadian] retail brokers can get quality execution and low-cost execution in Canada,” Kevan Cowan, TMX Group’s head of equities, said in an interview.

TMX Group said it couldn’t quantify the amount of retail order flow that its Toronto Stock Exchange and junior TSX Venture Exchange are losing to U.S. rivals, but “we are hearing from our customers that people are already doing this and others are considering it,” Mr. Cowan said.

Further moves by the brokerage arms of Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Toronto-Dominion Bank and others to route their retail order flow to the U.S. could threaten the effectiveness of Canada’s equity markets. Shrinking liquidity makes a stock market less appealing because it becomes harder and more costly for investors to execute their transactions.

TMX Group believes Canadian regulators will need to step in to completely resolve the issue because of difference in regulations governing rebates for U.S. broker-dealers and Canadian brokers, Mr. Cowan said.

Representatives for the retail brokerage arms of Canada’s big banks declined to comment on the matter, except RBC, which said it doesn’t routinely route retail stock orders to U.S. broker-dealers.

Write to Ben Dummett at ben.dummett@wsj.com and Rita Trichur at rita.trichur@wsj.com

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